It might work in the future. It might not. It is very common for some well-worn indicator that has always worked in the past to suddenly fail, a principle behind some of the "Dow 36,000" and "Dow Negative Infinity" hucksters.

There are many definitions of "risk". Although I haven't read the paper, I assume he is referring to "standard deviation" as "risk". This is misleading.

The P/E10 backtest tool will tell you to increase your stock allocation when business risk is high -- the very reason that causes P/E10 to fall. For those with short memories, I would imagine that the P/E10 tool would have told investors to load up on stocks during the financial meltdown of 2008-2009 when P/E10 fell below 15. However, I don't remember anyone telling investors that stocks were no longer as risky, do you?

There are many definitions of "risk". Although I haven't read the paper, I assume he is referring to "standard deviation" as "risk". This is misleading.

The P/E10 backtest tool will tell you to increase your stock allocation when business risk is high -- the very reason that causes P/E10 to fall. For those with short memories, I would imagine that the P/E10 tool would have told investors to load up on stocks during the financial meltdown of 2008-2009 when P/E10 fell below 15. However, I don't remember anyone telling investors that stocks were no longer as risky, do you?

BTW, what tool(s) are ya'll referring to for finding current/old PE 10s?

"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

The author compares 50/50 balanced fund to various PE10-based market-timing strategies over a 139-year period (1871 to 2010). In every case, the PE10 strategy blows the 50/50 portfolio out of the water in terms of risk-adjusted returns. For example, $1 invested in 1871 using the worst PE10 strategy in Figure II would grow to $94,866 in 2010. By comparison, a dollar invested in a 50/50 balanced fund would have grown to only $13,426. These two portfolios were comparable in terms of risk.

Other PE10-based market timing strategies are discussed that were much less volatile than a 50/50 balanced fund but provided substantially higher returns (see Figure V).

I encourage everyone here to read the study. The methods are clearly explained and can be understood by a layman.

I am very interested to hear your thoughts about the study. If you think a PE10 market timing approach will provide lower risk-adjusted returns than a 50/50 balanced fund going forward (i.e. the last 139 years were an anomaly), why do you think that?

The baseline market-timing strategy chooses either 100 percent stocks or 100 percent Treasury bills at the start of each year, depending on whether the value of PE10 is below or above its “historical average” at that time. ...When PE10 is above average, this suggests market overvaluation, and the investor chooses Treasury bills. When PE10 is below average, the investor chooses stocks. Following Fisher and Statman, I assume that 100 percent stocks is used (or the more aggressive allocation in later comparisons) for the years 1871-1880 when PE10 values could not yet be calculated.

The annualized return for that market timing strategy for large cap US stocks from Jan. 1871 to Jan. 2010 was 9.11% (I think that is total return) and the Standard Deviation (SD) was 13.93.
For 100% stocks the return was 8.60% with an SD of 18.02.
For 50% stocks/50% T-bills rebalanced at the beginning of each year, the return was 7.08% with an SD of 8.98.
(All the statistics above are from p. 8 of the article.)

I'd be surprised if the extra return of that market timing strategy would make up for the tax costs and trading costs of the extra trading. Also, since it's an all or none strategy, that makes it more difficult as an investor to stay faithful to the strategy at times when the strategy is not working.

I wonder what the results would be if the timing was based on whether the markets were above or below the historical average of: 1/PE10 - the 10-year treasury bond yield.

Last edited by docneil88 on Sat May 28, 2011 11:01 pm, edited 1 time in total.

would, I think, have less risk than a regularly rebalanced 50/50 portfolio while probably outperforming it.

W Bern writes in his book, "About once every generation the markets go barking mad." If you know this is true, and you are objective enough to stay above the fray when it occurs (typically selling euphoria and buying despair), wouldn't that intuitively provide higher returns with lower risk? What is the evidence that acting on PE10 does NOT juice returns without increasing risk?

There are other ways besides PE10 to value the market. Stein and Demuth published along the same thought line in "Yes You Can Time The Market" showing that if you buy when various valuation metrics are below their 15 year trailing averages, you outperform buy-and-hold. The metrics include PE, P/S, P/B, dividend yield, etc.

Ben Graham argued that stocks can be attractive or not depending on valuations and that one's equity allocation might vary from as high as 75% to as low as 25% depending on those valuations.

Warren Buffett says "stocks are the only thing people don't like to buy on sale."

Ed Easterling in "Unexpected Returns" shows that the top 10%ile of 20 year market returns (range of annualized returns 11.9% to 15.0%) began with an average PE of 10 and ended with an average PE of 29. The bottom 10%ile of 20 year returns (annualized returns 1.2% to 4.5%) began with an average PE of 19 and ended with an average PE of 9. He provides additional evidence that initial dividend ratios are correlated with 20 year returns.

Even Jack Bogle concedes that some amount of tactical asset allocation (based on valuation) may be useful.

The biggest drawback to this approach is that it takes nerves of steel to use. You must not only buy when stocks are getting clobbered - you must overbuy. And you must sell and sell some more when everyone at the water cooler is getting richer by the day trading AMZN and YHOO and whatever else was popular in 1999. But if one can tolerate the short to medium term tracking error, the results should be quite pleasing in the end.

Actually, contrary to what many Bogleheads believe, even EMH-loving academics find this type of market timing theoretically kosher. Why? During bad times, the story goes, the rational reward for risk has to go up to compensate for the market's reduced willingness to bear potential losses. In other words, equities don't have a constant risk-reward relationship through time.

The behavioralist theory is much more elegant, in my opinion. During bad times, we have the tendency to hyperbolically discount future cash flows and we overextrapolate current trends. All you have to do is look within yourself or in others to see that this is true, nevermind the mountain of experiments supporting this position. There's surprisingly little rational calculation going on when fear is in the air.

docneil88 wrote:I'd be surprised if the extra return of that market timing strategy would make up for the tax costs and trading costs of the extra trading.

If you look at the growth of 1 dollar invested 139 years ago, the all-or-nothing valuation-based market timing strategy provides 7 times higher returns than the 50/50 balanced fund. I see how taxes could shrink the difference, but it is not plausible that they would eliminate the entire discrepancy. Trading costs are so low nowadays that it is reasonable to ignore them entirely, except if you are buying thinly-traded equities.

docneil88 wrote:Also, since it's an all or none strategy, that makes it more difficult as an investor to stay faithful to the strategy at times when the strategy is not working.

This is a valid point. It would be psychologically difficult to "overbalance" into equities at times when equities are most despised. If you read the paper, you'll see that Pfau considers both all-or-nothing valuation-based strategies as well as "partial-shift" valuation-based strategies. The latter produce lower returns than all-or-nothing strategies but are still greatly superior to the 50/50 balanced fund in terms of risk-adjusted returns.

Last edited by fredflinstone on Sun May 29, 2011 5:37 am, edited 2 times in total.

fredflinstone wrote:If you look at the growth of 1 dollar invested 139 years ago, the all-or-nothing valuation-based market timing strategy provides 7 times higher returns than the 50/50 balanced fund. I see how taxes could shrink the difference, but it is not plausible that they would eliminate the entire discrepancy.

Hi Fred, 7X sounds like a lot, but it's over the span of 129 years. The difference in annualized return is 9.11% vs. 7.08%, a difference that I still believe would be mostly eaten up by the higher taxes involved with a strategy that has much higher turnover than buying and holding a broad index fund. Best, Neiledits in blue based on fredflinstone's comment immediately below.

Last edited by docneil88 on Sun May 29, 2011 3:16 pm, edited 1 time in total.

fredflinstone wrote:If you look at the growth of 1 dollar invested 139 years ago, the all-or-nothing valuation-based market timing strategy provides 7 times higher returns than the 50/50 balanced fund. I see how taxes could shrink the difference, but it is not plausible that they would eliminate the entire discrepancy.

Hi Fred, 7X sounds like a lot, but it's over the span of 129 years. The difference in annualized return is 9.11% vs. 8.98%, a difference that I still believe could be eaten up by the higher taxes involved with a strategy that has much higher turnover than buying and holding a broad index fund. Best, Neil

Nearly every investor, at one time or another, is intrigued by market timing schemes. However, I have learned from personal experience that market-timing is a dangerous game as these experts explain:

"The stock market will fluctuate, but you can't pinpoint when it will tumble or shoot up. If you have allocated your assets properly and have sufficient emergency money, you shouldn't need to worry." (AAII Guide to Mutual Funds)

"Endless tinkering is unlikely to improve performance, and chasing last period's stellar achiever is a losing strategy." (Frank Armstrong, author and adviser)

"It must be apparent to intelligent investors--if anyone possessed the ability to do so (market time) he would become a billionaire--quickly--." (David Babson, author, adviser)

"What it really takes to improve your returns and diminish your risks is a willingness to stop focusing exclusively on the movement of the markets." (Baer & Ginsler, The Great Mutual Fund Trap)

"If we haven't said it enough, we'll say it again: Market timing is dangerous." (Barron's Guide to Making Investment Decisions.)

"Only liars manage to always be "out" during bad times and "in' during good times. (Bernard Baruch, famed investor)

"Market timing recommendations have an impressive track record of being harmful to an investor's financial health." (Peter Bernstein, author, researcher)

"There are two kinds of investors, be thay large or small: those who don't know where the market is headed, and those who don't know that they don't know." (Wm Bernstein, author and adviser)

The Boglehead (forecasting) Contest began in 2001. Of 99 Diehard guesses that year, only 11 even guessed the direction of the stock market. In January 2008, only 2 Bogleheads guessed how low the S&P would go. Of 11 professional forecasters, every one thought the S&P would gain (it declined -38%)

"If you're determined to succeed at investing, make it your first priority to become a buy-and-hold investor." (Jack Brennan, Straight Talk on Investing)

"For the 12 years ending 1997, while the S&P rose 734% on a total return basis, the average return for 186 tactical asset-allocation mutual funds was a mere 384%. (Buckingham Financial Services)

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two." (Warren Buffet)

"Do nothing. I think all of this market timing is statistically unfounded. I don't trust it. You may avoid a downturn, but you may also miss the rise. Choose the risk tolerance you're OK with and hold tight." (Professor Eugene Fama)

"The best practice for investors is to design a long-term globally diversified asset allocation based on present and future financial needs. Then follow that plan religiously, through all markets good and bad." (Rick Ferri, author and adviser)

"Benjamin Graham spent much of his career trying to devise a goodformula for when to get into--and out of--the stock market. All formulas, he concluded, failed." (Forbes, 12-27-99)

"Buy and hold. Diversify. But your money in index funds. Pay attention to the one thing you can control--costs." (Fortune Investor's Guide)

"Dont' sell out of fear or buy out of greed. Just keep making investments, and let the market take its course over the long-term." (Norman Fosback, author, researcher)

"The only function of economic forecastng is to make astrology look respectful." (John Kenneth Galbraith, Economist)

"After receiving the Nobel Prize, Daniel Kahneman, was asked by a CNBC anchorman what investment tips he had for viewers. His answer: "Buy and hold."

"Timing the market is for losers. Time IN the market will get you to the winner's circele, and you'll sleep better at night." (Michael Leboeuf, author)

"No one is smart enough to time the market's ups and downs." (Arthur Levitt, former SEC chairman)

"It never was my thinking that made the big money for me. It always was my sitting." (Jesse Livermore, author & famed investor)

"Nobody can predict interest rates, the future direction of the economy or the stock market." (Peter Lynch)

"Buying-and-holding a broad-based market index fund is still the only game in town." (Burton Malkiel, Random Walk Down Wall Street)

"At the peak of the bull market in March of 2000 only 0.7% of all recommendations on stocks issued by Wall Street brokerages and investment banks were to "Sell." (Miami Herald, 1-26-03)

"If you can't handle the short term, if the uncertainty is stressful and the headlines are unbearable, then the markets are too hot for you: get out of the kitchen." (Moshe Milevsky, author & researcher)

"We're not keen on market-timing. It just doesn't work." (Morningstar Course 106)

"Odean and Barber tested over 66,400 investors between 1991 and 1997. Their findings: "The most active traders earned 7% less annually than buy-and-hold investors."

"Forget trying to time the market and do something productive instead." (Gerald Perritt, financial author)

"The market timer's Hall of Fame is an empty room." (Jane Bryant Quinn)

"Countless studies have proved that no one is able to time the market effectively." (Mary Roland, author & journalist)

"Trading is based on the rather arrogant belief that the trader knows more than the buyers and sellers with whom he is trading." (Ron Ross, The Unbeatable Market)

"In the long run it doesn't matter much whether your timing is great or lousy. What matters is that you stay invested." (Louis Rukeyser, TV host)

"For the 10 years that ended 12-31-2000, only one newsletter out of the 112 that Timers Digest follows managed to beat the S&P 500 Benchmark." (Jim Schmidt, editor)

"What do I really think is going to happen? -- I have absolutely no idea. (John Schoen, senior producer for msnbc.com)

"I have learned the hard way that market timing and trying to pick a fund that will out-perform the market are both losing strategies." (Larry Schultheis, author and advisor)

"I'm a strong advocate of buying and holding." (Charles Schwab)

"It turns out that I should have just bought them (securities), and thereafter I should have just sat on them like a fat, stupid peasant. A peasant however, who is rich beyond his limited dreams of avarice." (Fred Schwed Jr., 'Where are the Customers' Yachts?)

"If you are not going to stick to your chosen investment method through thick and thin, there is almost no chance of your succeeding as an investor. (Chandan Sengupta, financial author)

"Investors should look with a jaundiced eye at any market timing system being peddled by its guru-creator." (W. Scott Simon, financial author)

"Buying and holding a few broad market index funds is perhaps the most important move ordinary invests can make to supercharge their portfolios." (Stein & DeMuth, (authors & advisor)

"If you buy, and then hold a total-stock-market index fund, it is mathematically certain that you will outperform the vast majority of all other investors in the long run." (Jason Zweig, author, Wall Street Journal Columnist)

"I do not know of anybody who has done it (market timing) successfully and consistently. I don't even know anybody who knows anybody who has done it successfully and consistently." (Jack Bogle)

Buying when stocks are, in general, cheap is always a good idea. Hard to define when things are cheap and it's not clear that PE10 is better than other valuation metrics. They all have their utility as well as their weaknesses.

You can back test for many things over 139 years and find that some factor gave you larger returns (buying in odd years instead of even, for instance). My point is that you could come up with 20 fancy theories for how to time the market, backtest them all from 139 years ago and some of these theories, even rather preposterous ones, would beat the market. It doesn't necessarily mean any of them will beat the market over the next 139 years.

In general, however, I would concede that value will beat over the long-term, so any buying strategy based on some valuation metric has an inherent advantage. Having said that, growth might annhiliate value over the next decade.

Nearly every investor, at one time or another, is intrigued by market timing schemes. However, I have learned from personal experience that market-timing is a dangerous game as these experts explain:

"The stock market will fluctuate, but you can't pinpoint when it will tumble or shoot up. If you have allocated your assets properly and have sufficient emergency money, you shouldn't need to worry." (AAII Guide to Mutual Funds)

"Endless tinkering is unlikely to improve performance, and chasing last period's stellar achiever is a losing strategy." (Frank Armstrong, author and adviser)

"It must be apparent to intelligent investors--if anyone possessed the ability to do so (market time) he would become a billionaire--quickly--." (David Babson, author, adviser)

"What it really takes to improve your returns and diminish your risks is a willingness to stop focusing exclusively on the movement of the markets." (Baer & Ginsler, The Great Mutual Fund Trap)

"If we haven't said it enough, we'll say it again: Market timing is dangerous." (Barron's Guide to Making Investment Decisions.)

"Only liars manage to always be "out" during bad times and "in' during good times. (Bernard Baruch, famed investor)

"Market timing recommendations have an impressive track record of being harmful to an investor's financial health." (Peter Bernstein, author, researcher)

"There are two kinds of investors, be thay large or small: those who don't know where the market is headed, and those who don't know that they don't know." (Wm Bernstein, author and adviser)

The Boglehead (forecasting) Contest began in 2001. Of 99 Diehard guesses that year, only 11 even guessed the direction of the stock market. In January 2008, only 2 Bogleheads guessed how low the S&P would go. Of 11 professional forecasters, every one thought the S&P would gain (it declined -38%)

"If you're determined to succeed at investing, make it your first priority to become a buy-and-hold investor." (Jack Brennan, Straight Talk on Investing)

"For the 12 years ending 1997, while the S&P rose 734% on a total return basis, the average return for 186 tactical asset-allocation mutual funds was a mere 384%. (Buckingham Financial Services)

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two." (Warren Buffet)

"Do nothing. I think all of this market timing is statistically unfounded. I don't trust it. You may avoid a downturn, but you may also miss the rise. Choose the risk tolerance you're OK with and hold tight." (Professor Eugene Fama)

"The best practice for investors is to design a long-term globally diversified asset allocation based on present and future financial needs. Then follow that plan religiously, through all markets good and bad." (Rick Ferri, author and adviser)

"Benjamin Graham spent much of his career trying to devise a goodformula for when to get into--and out of--the stock market. All formulas, he concluded, failed." (Forbes, 12-27-99)

"Buy and hold. Diversify. But your money in index funds. Pay attention to the one thing you can control--costs." (Fortune Investor's Guide)

"Dont' sell out of fear or buy out of greed. Just keep making investments, and let the market take its course over the long-term." (Norman Fosback, author, researcher)

"The only function of economic forecastng is to make astrology look respectful." (John Kenneth Galbraith, Economist)

"After receiving the Nobel Prize, Daniel Kahneman, was asked by a CNBC anchorman what investment tips he had for viewers. His answer: "Buy and hold."

"Timing the market is for losers. Time IN the market will get you to the winner's circele, and you'll sleep better at night." (Michael Leboeuf, author)

"No one is smart enough to time the market's ups and downs." (Arthur Levitt, former SEC chairman)

"It never was my thinking that made the big money for me. It always was my sitting." (Jesse Livermore, author & famed investor)

"Nobody can predict interest rates, the future direction of the economy or the stock market." (Peter Lynch)

"Buying-and-holding a broad-based market index fund is still the only game in town." (Burton Malkiel, Random Walk Down Wall Street)

"At the peak of the bull market in March of 2000 only 0.7% of all recommendations on stocks issued by Wall Street brokerages and investment banks were to "Sell." (Miami Herald, 1-26-03)

"If you can't handle the short term, if the uncertainty is stressful and the headlines are unbearable, then the markets are too hot for you: get out of the kitchen." (Moshe Milevsky, author & researcher)

"We're not keen on market-timing. It just doesn't work." (Morningstar Course 106)

"Odean and Barber tested over 66,400 investors between 1991 and 1997. Their findings: "The most active traders earned 7% less annually than buy-and-hold investors."

"Forget trying to time the market and do something productive instead." (Gerald Perritt, financial author)

"The market timer's Hall of Fame is an empty room." (Jane Bryant Quinn)

"Countless studies have proved that no one is able to time the market effectively." (Mary Roland, author & journalist)

"Trading is based on the rather arrogant belief that the trader knows more than the buyers and sellers with whom he is trading." (Ron Ross, The Unbeatable Market)

"In the long run it doesn't matter much whether your timing is great or lousy. What matters is that you stay invested." (Louis Rukeyser, TV host)

"For the 10 years that ended 12-31-2000, only one newsletter out of the 112 that Timers Digest follows managed to beat the S&P 500 Benchmark." (Jim Schmidt, editor)

"What do I really think is going to happen? -- I have absolutely no idea. (John Schoen, senior producer for msnbc.com)

"I have learned the hard way that market timing and trying to pick a fund that will out-perform the market are both losing strategies." (Larry Schultheis, author and advisor)

"I'm a strong advocate of buying and holding." (Charles Schwab)

"It turns out that I should have just bought them (securities), and thereafter I should have just sat on them like a fat, stupid peasant. A peasant however, who is rich beyond his limited dreams of avarice." (Fred Schwed Jr., 'Where are the Customers' Yachts?)

"If you are not going to stick to your chosen investment method through thick and thin, there is almost no chance of your succeeding as an investor. (Chandan Sengupta, financial author)

"Investors should look with a jaundiced eye at any market timing system being peddled by its guru-creator." (W. Scott Simon, financial author)

"Buying and holding a few broad market index funds is perhaps the most important move ordinary invests can make to supercharge their portfolios." (Stein & DeMuth, (authors & advisor)

"If you buy, and then hold a total-stock-market index fund, it is mathematically certain that you will outperform the vast majority of all other investors in the long run." (Jason Zweig, author, Wall Street Journal Columnist)

"I do not know of anybody who has done it (market timing) successfully and consistently. I don't even know anybody who knows anybody who has done it successfully and consistently." (Jack Bogle)

With all due respect, Taylor, some of these gurus you have cited are not uniformly opposed to valuation-based market-timing.

I am no fan of Stein & DeMuth, but let's be clear about where they stand on this issue.

Their book is praised by Jonathan Clements, one of the gurus you cited above.

I've seen no evidence that Larry Swedroe supports market-timing in equities, but he does advocate switching from short-term bonds to TIPS when real yields are high. I don't think he considers this valuation-based market timing of TIPS, but in my view that is what it is.

as letsgobobby notes above, "Ben Graham argued that stocks can be attractive or not depending on valuations and that one's equity allocation might vary from as high as 75% to as low as 25% depending on those valuations."

Even Jack Bogle has spoken positively about tactical asset allocation based on valuation. I have read that he reduced his equity allocation near the 2000 market top. This is not the "Stay the Course" approach that he often advocates.

More recently Mr. Bogle expressed nervousness about fixed-income markets and advocated a mix of short- and intermediate-duration bonds:

One can agree or disagree with Mr Bogle and Dr Bernstein, but let's call their current approach to fixed income investments what it is: valuation-based market timing.

Let me say that again. If you are switching from intermediate-term bonds to limited-term or short-term bonds based on current conditions in fixed-income markets, you are engaging in market timing.

Some of the "experts" you cite are not really experts. The Motley Fool? The Miami Herald? Others I have not heard of, so I cannot say whether they have any more expertise than I do.

Many of the experts you cite assert that market-timing cannot beat a buy-and-rebalance approach. I assume that they are talking about the futility of predicting short-term moves in the market. Or perhaps they are unaware of Professor Pfau's recent research.

Pfau's paper demonstrates convincingly that a valuation-based long-term market-timing approach can and does beat a 50/50 balanced fund--and does so by a large margin. I recommend that you read his paper. It is clearly written and can be understood by those of us who do not have technical expertise in finance.

I am open to the possibility that Pfau has made a mistake in his research, but I have yet to see any evidence of that.

William Million wrote:You can back test for many things over 139 years and find that some factor gave you larger returns (buying in odd years instead of even, for instance). My point is that you could come up with 20 fancy theories for how to time the market, backtest them all from 139 years ago and some of these theories, even rather preposterous ones, would beat the market. It doesn't necessarily mean any of them will beat the market over the next 139 years.

True. But when an investment approach is strongly supported by both empirical evidence (139 years of U.S. data) and common sense (buy when cheap, sell when expensive) then it is probably going to continue to work well in the future.

By the way, Professor Pfau replicated his research in Japan and came up with similar results. The successful "out-of-sample" performance of valuation-based market timing reinforces the arguments for it.

I have yet to see any evidence that Pfau's research is flawed in any significant respect.

fredflinstone wrote:
I am open to the possibility that Pfau has made a mistake in his research, but I have yet to see any evidence of that.

Here's what I told Wade when he said that he would still be working on the paper after he takes his CFA exam:

Mel Lindauer wrote:And while you're at it, Wade, don't forget to take taxes and trading costs into consideration since that would certainly change the outome vs buy-and-hold.

Remember, tax-deferred accounts didn't exist for most of the period studied, which means most of this trading activity would have had to been accomplished in taxable accounts. And you need to consider the tax rates that were in effect at the various times as well as the brokerage charges and sales loads that were in effect at the various times the trades were made. Investing and trading were very expensive prior to Jack Bogle and Vanguard.

About the exam, the whole time I've been studying, I've been filling the books with (*) every time I see an interesting comment or caveat that is relevant for this topic. I've got to get that all sorted down to some key themes.

Last edited by wade on Sun May 29, 2011 8:18 am, edited 1 time in total.

I did consider a number of risk measures, but I think his point is that all my risk measures are about ex-post results, not what people were experiencing ex-ante. So far in US history, things have tended to work out in the end for asset markets, and so the valuation-based approach has "worked", but at various points in history people may have really been feeling like it was the beginning of the end.

William Million wrote:You can back test for many things over 139 years and find that some factor gave you larger returns (buying in odd years instead of even, for instance). My point is that you could come up with 20 fancy theories for how to time the market, backtest them all from 139 years ago and some of these theories, even rather preposterous ones, would beat the market. It doesn't necessarily mean any of them will beat the market over the next 139 years.

True. But when an investment approach is strongly supported by both empirical evidence (139 years of U.S. data) and common sense (buy when cheap, sell when expensive) then it is probably going to continue to work well in the future.

Using decades of data and common sense (they called it the "lottery effect"), many experts said small growth stocks should be avoided at all costs in the 90s. Out of sample, they've been the best performing asset class.

fredflinstone wrote:By the way, Professor Pfau replicated his research in Japan and came up with similar results. The successful "out-of-sample" performance of valuation-based market timing reinforces the arguments for it.

Japan had high P/Es in the 1950s and 60s, yet very strong stock performance for the next 30 years.

Thinking you can detect patterns in the market that are sure to continue going forward is tempting, but a fool's game in my opinion.

Two points. First this whole approach cries out for sensitivity studies that could be easily done but were not. The author says re PE10 "there is no particular theoretical reason to pick precisely 10 years", but does. Also says "there is no particular need to test whether other measures would produce better results" and doesn't. He does not even bother to mention anything about no particular reason to choose the first day of January to make your in\out decision for the year.

There sure as heck are reasons to investigate other measures. The good results are probably dominated by a few happy timing events, e.g. looks like you would have had no stocks through 28-1932, probably good but depends on the exact price the day you got in/out at. IMO there will be a big std deviation of random results depending on which of the 1000's of alternate choices of averaging period and sales day of the year you might pick. I found such when simulating M. Faber's timing system using different calendar days of the month trading. Results are all over the place. Faber's use of the last day cheery picks the one with the best results. The market can't count to 10 or read a calender so if there is a big sigma for this PE10/Jan1 method then wildly different results could happen in the future. Maybe PE10/Jan 1 returns are way out on the high side of the distribution. On the other hand if the system works for most of the ensemble of measures then that's altogether different. Too bad Pfau was lazy about looking into sensitivites .

Second point is just that who will have the patience for this sitting out of stocks from 1988 to 2009.
JW

Last edited by JW-Retired on Tue May 31, 2011 9:13 am, edited 1 time in total.

William Million wrote:You can back test for many things over 139 years and find that some factor gave you larger returns (buying in odd years instead of even, for instance). My point is that you could come up with 20 fancy theories for how to time the market, backtest them all from 139 years ago and some of these theories, even rather preposterous ones, would beat the market. It doesn't necessarily mean any of them will beat the market over the next 139 years.

True. But when an investment approach is strongly supported by both empirical evidence (139 years of U.S. data) and common sense (buy when cheap, sell when expensive) then it is probably going to continue to work well in the future.

By the way, Professor Pfau replicated his research in Japan and came up with similar results. The successful "out-of-sample" performance of valuation-based market timing reinforces the arguments for it.

I have yet to see any evidence that Pfau's research is flawed in any significant respect.

If the buying only in odd years beat the market over the past 139 years, why not adopt that strategy?

Of course, if buying in odd years did not beat the market, that means buying in even years beat the market and you should adopt that approach, since the "evidence" supports it. You can come up with a lot of approaches that beat the market over the past 139 years, but that doesn't mean you wouldn't be nuts for following those strategies for the next 139 years.

If you decide to use that PE10 metric and you beat buy and hold from day one, no problem. But even if you believe in it, you would probably concede that you could underperform for a while? So you should also decide: After how many years of underperformance, will you call it quits and abandon this market-timing strategy? 5? 10? 20? That's oen of the problems with market-timing. Even if you're right, you might give up in year 15. Then years 16-20 is when you would have blown past buy-and-hold.

JW Nearly Retired wrote:Two points. First this whole approach cries out for sensitivity studies that could be easily done but were not. The author says re PE10 "there is no particular theoretical reason to pick precisely 10 years", but does. Also says "there is no particular need to test whether other measures would produce better results" and doesn't. He does not even bother to mention anything about no particular reason to choose the first day of January to make your in\out decision for the year.

It would be nice to see sensitivity, but if I were to pick specific numbers to study so that I wouldn't be accused of data mining, PE10 and Jan 1 (or Dec 31, which comes to the same place) would be the natural choices. January 1 seems the obvious choice for an annual event.

JW Nearly Retired wrote:Second point is just that who will have the patience for this sitting out of stocks from 1988 to 2009.

Many wouldn't. There's lots of reports of value funds suffering from massive redemptions toward the end of this period (which was a large mistake in hindsight). However, to criticize a strategy because it takes a lot of discipline to follow is not a very good criticism. Buying stocks after they've plunged is hard, yet rebalancing is widely recommended. If you want to beat the market, any strategy will have to be hard to work.

William Million wrote:If the buying only in odd years beat the market over the past 139 years, why not adopt that strategy?

Of course, if buying in odd years did not beat the market, that means buying in even years beat the market and you should adopt that approach, since the "evidence" supports it. You can come up with a lot of approaches that beat the market over the past 139 years, but that doesn't mean you wouldn't be nuts for following those strategies for the next 139 years.

There's a reasonable theoretical justification for timing based on PE10. There really isn't one for odd/even years.

William Million wrote:If you decide to use that PE10 metric and you beat buy and hold from day one, no problem. But even if you believe in it, you would probably concede that you could underperform for a while? So you should also decide: After how many years of underperformance, will you call it quits and abandon this market-timing strategy? 5? 10? 20? That's oen of the problems with market-timing. Even if you're right, you might give up in year 15. Then years 16-20 is when you would have blown past buy-and-hold.

As I mentioned above, that's true of any strategy.

How many decided not to rebalance into stocks when the S&P 500 was in the 800 range a few years ago?

JW Nearly Retired wrote:Second point is just that who will have the patience for this sitting out of stocks from 1988 to 2009.

Many wouldn't. There's lots of reports of value funds suffering from massive redemptions toward the end of this period (which was a large mistake in hindsight). However, to criticize a strategy because it takes a lot of discipline to follow is not a very good criticism. Buying stocks after they've plunged is hard, yet rebalancing is widely recommended. If you want to beat the market, any strategy will have to be hard to work.

These things don’t have to be cliffs you jump off.
You could have a 25% equity allocation “no matter what”
And only buy up to a 75% allocation “no matter what“.

JW Nearly Retired wrote:IMO, it doesn't really matter much if you data mine accidently by picking the "obvious choice", or because you are just lazy and want to publish something quickly, or if you do it because it gives the most impressive results. The results are equally misleading in all cases. You need to look at all the data and analyzed it in more then one narrow way.

The worse problem, IMO, is that this paper is a response to an article by Fisher & Statman. If I'm reading correctly, they switch at the point p/e ratios move out of range, rather than waiting until some specific annual date. If so, why this change in methodology?

I believe Campbell & Schiller and Campbell & Viceira, in related papers, also switched when ratios moved out of range, rather than testing on a specific date.

If so, why this change in methodology? Why not use the method from the earlier research?

We do appear to have a different take on the meaning of data mining. To me, choosing a reasonable hypothesis and testing it is not data mining. Testing lots and picking the best without theoretical justification is data mining. However, given that the earlier research used a different methodology (assuming my quick browse is accurate) does raise these issues.

Last edited by richard on Sun May 29, 2011 10:21 am, edited 1 time in total.

Taylor:
Pfau's paper demonstrates convincingly that a valuation-based long-term market-timing approach can and does beat a 50/50 balanced fund--and does so by a large margin. I recommend that you read his paper.

I did read his paper:

In order to help avoid data mining, the rolling median measure will be used in subsequent comparisons.

For the market-timing strategy based on the rolling median PE10 value, the slightly lower
wealth accumulation results from a geometric return of 8.59 percent, compared to 8.6 percent for
the buy-and-hold strategy. The two strategies provide, essentially, the same returns.

bob90245 wrote:The P/E10 backtest tool will tell you to increase your stock allocation when business risk is high -- the very reason that causes P/E10 to fall. For those with short memories, I would imagine that the P/E10 tool would have told investors to load up on stocks during the financial meltdown of 2008-2009 when P/E10 fell below 15. However, I don't remember anyone telling investors that stocks were no longer as risky, do you?

This is a fundamental point. Low p/e means the market is telling you risk is high (and vice versa). You would expect to get higher returns because risk is higher. Of course, expected returns do not necessarily equal actual returns, or it would not be the case that risk was higher.

Getting higher returns by taking on more risk should not be surprising.

at this point are some arguing that valuation is no useful predictor of returns at all, or that PE10 may not be accurate or sensitive enough to use as the valuation indicator?

With regards to it being hard to do, perhaps - but not impossible. My stock exposure was never higher than 30% or so before 2008, and by fall 2009 it was almost 70%. Adrian Nenu went 100% stocks at some opportune moment during the 2008-09 crash. If I can do it (with no formal business or investment experience or education), certainly many others can. Certainly most Bogleheads could - they just don't believe the data and so they don't.

with regards to the home-country and recency bias of using US stock returns to justify the approach, today's mutual fund marketplace means one can now own the total world stock market at very low cost. At that point there is no single-country or recency bias. Most Bogleheads have large international allocations, thus investing in worldwide economic growth without attempting to pick winners.

Using a 401k and an IRA, most Bogleheads have substantial tax-advantaged accounts at their disposal. Thus many of the concerns Mel and Taylor have highlighted regarding fees and taxes are no longer dealbreakers.

Does it not make sense that buying things on sale is better? Since PE expansion is a major component of returns during secular bull markets, is it not obvious that buying at very very high PE cannot allow this to happen? And that buying at very very low PE makes it more likely for this to happen?

One other issue about this approach: if in the heat of the moment one does NOT follow it (say, when PE10 falls to 10 one does not overincrease stocks), then the cost of NOT following the strategy is still zero, assuming one follows the basic Boglehead tenet of at least rebalancing to maintain AA. What other strategy gives you the opportunity to increase returns without sacrificing the returns straight indexing and rebalancing "should" give you in the first place?

letsgobobby wrote:Does it not make sense that buying things on sale is better?

Using a popular image, if hamburger is cheap today, is it because you're getting regular hamburger at a good price or is it because the hamburger is lower quality?

The stock could be on sale because it's riskier.

A stock is worth the discounted present value of its future cash flows. We don't know the future cash flows. Past cash flows are a very imperfect estimate of future values. In other words, we don't really know if the stock is on sale or not.

Compare bonds (not a perfect comparison). We don't price bonds based on the ratio of today's price to last year's interest, we price based on the interest it will pay in the future, which is essentially a known quantity for high quality bonds.

"It is quite ironic that you would question this market timing startegy because it is well known that you yourself are a timer.
Probably the most well-known timer there is, short of Big Ben. Every EE knows exactly what I'm talking about.http://en.wikipedia.org/wiki/555_timer_IC "

That's actually very funny :lol: though I had to click in the link to figure out why

richard wrote: We do appear to have a different take on the meaning of data mining. To me, choosing a reasonable hypothesis and testing it is not data mining. Testing lots and picking the best without theoretical justification is data mining. However, given that the earlier research used a different methodology (assuming my quick browse is accurate) does raise these issues.

Pfau cannot know that he hasn't picked some extreme outlier case in the data. Whatever you call it, having a huge set of data and arbitrarily throwing away all but an infinitesimal subset of it to analyze is shoddy and likely to be misleading. There are 200 and something closing prices a year and all but one are ignored. He should have tried trading on all of them. You could also reasonably try PE6/7/8/9/10/11/12 whatever. Trying a couple of thousand combinations of equally "reasonable" hypotheses is just some number crunching that could be done easily. If you get a small standard deviation of results over these 1000's of cases we would get some confidence this should work. Large deviation forget it. My bet would be on a large std deviation but I'm willing wait to see.

Prof Pfau's paper is much like him digging one shovel of dirt out of the ground, finding one gold nugget, and immediately putting his "gold mine" up for sale. Nobody had better buy that mine until it's proven that random shovelful is not some fluke.

I really cannot understand why some finance grad student hasn't done this sort of analysis right. Could it be they have but didn't publish it because proving you can't beat the market doesn't look good on a finance resume? Nah, more likely it's just lazyness.
JW

Nope. Among other things, following convention is actually a pretty good check on data-mining.

peter71 wrote:Nope. Among other things, following convention is actually a pretty good check on data-mining.

That's what I now consider a problem. He seems to have switched from the convention used in earlier studies (switching if the metric is over the line on Jan 1 rather than when the metric crosses the line). If so, he's not following convention.

But I certainly agree with your disagreement with a post that disagrees with me.

peter71 wrote:Nope. Among other things, following convention is actually a pretty good check on data-mining.

That's what I now consider a problem. He seems to have switched from the convention used in earlier studies (switching if the metric is over the line on Jan 1 rather than when the metric crosses the line). If so, he's not following convention.

But I certainly agree with your disagreement with a post the disagrees with me.

Hi Richard,

I think the Jan 1 switch could be defended on the grounds of ease of implementation, and I actually think any retrospective switch date you pick is tricky in that earnings data aren't continuously updated, but I think various backwards-looking work including Norbert Schlenker's suggests more support for a switching strategy than Meir and Statman . . .

Having said all that I think the market is now rationally and predictably self-adjusting to the new conventional wisdom that valuations matter . . . I don't think we'll again see a P/E 10 anywhere close to the 40 levels that help drive the success of this strategy, and I think the reasons P/E 10's are now as high as they are are quite sensible: e.g., much lower P/E 1's, the decreasing salience of q in an era of globalization, positive momentum, and above all, extraordinarily low interest rates which make stocks relatively far more appealing than they normally would be with P/E's at this level . . .

letsgobobby wrote:If I can do it (with no formal business or investment experience or education)

If you really can "do it" consisently, you can make it into the Forbes 400 pretty easily with a little leverage. Never confuse luck with skill.

letsgobobby wrote:Does it not make sense that buying things on sale is better?

Using that logic, if a company declares bankruptcy, and its stock drops to zero, it must be an incredible deal. Look at that low price! Alas, stocks drop (and rise) for a reason.

Nick

both you and richard are conflating comments about the world's total equity and individual stocks. Obviously an individual stock (company) can be worth zero. It is nearly impossible that the entire world's future corporate earnings can be zero forever, unless we are in WWIII, in which case none of this matters at all. Implicit in any rational asset allocation is that the world will go on... companies (en total) have some value. that is why a broadly diversified valuation strategy works... even though an individual company, sector, or even country may go to zero, the entire world will not. Using richard's analogy, while the hamburger may reek, the entire global food supply will not rot within the 7 day sell-by date.

I read your link to Adrian and it's clear the context was suggesting what an inverted yield curve might mean - you know and I know he publicly advertised his 100% stock position.

as for today, PE10 - if it has any predictive value at all - is predictive only at the extremes. Today's PE10 23.8 or so is still in the broad range where my view is it doesn't predict much of anything, nothing actionable at any rate. Maybe others are smarter. So for me, I stick with my AA, which is about 55-57/43-45. If PE10 climbs above 25 I may react.

The ability to have a very long-term view is a gift that only individual investors can have. It doesn't seem hedge fund managers, mutual fund managers, or pension fund managers have that luxury. In that sense, since valuation metrics only work to assess long-term (and not short-term) results, maybe the individual has an advantage.

letsgobobby wrote:The ability to have a very long-term view is a gift that only individual investors can have. It doesn't seem hedge fund managers, mutual fund managers, or pension fund managers have that luxury. In that sense, since valuation metrics only work to assess long-term (and not short-term) results, maybe the individual has an advantage.

I can see that hedge fund and retail mutual fund managers likely have a short-term focus. But tell me why a pension fund manager would opt for a short-term rather than a long-term focus? My understanding is that at least 40% of pension funds employ a passive strategy using index funds to implement their Investment Policy Statement (IPS).

Taylor:
Pfau's paper demonstrates convincingly that a valuation-based long-term market-timing approach can and does beat a 50/50 balanced fund--and does so by a large margin. I recommend that you read his paper.

I did read his paper:

In order to help avoid data mining, the rolling median measure will be used in subsequent comparisons.

For the market-timing strategy based on the rolling median PE10 value, the slightly lower
wealth accumulation results from a geometric return of 8.59 percent, compared to 8.6 percent for
the buy-and-hold strategy. The two strategies provide, essentially, the same returns.

Past performance is no guarantee of future performance.

Taylor, I think you may be misunderstanding the result you cited above. This is the part of the paper where Pfau compares a 100% buy-and-hold-forever stock strategy to the much lower-risk Market Timing approach. His point is that the Market Timing approach produces essentially the same returns as 100% equities but with much lower risk. If you look later in the paper you will see that the Market Timing approach produces much higher returns than a 50/50 balanced fund but with similar risk.

richard wrote: It would be nice to see sensitivity, but if I were to pick specific numbers to study so that I wouldn't be accused of data mining, PE10 and Jan 1 (or Dec 31, which comes to the same place) would be the natural choices. January 1 seems the obvious choice for an annual event.

IMO, it doesn't really matter much if you data mine accidently by picking the "obvious choice", or because you are just lazy and want to publish something quickly, or if you do it because it gives the most impressive results. The results are equally misleading in all cases. You need to look at all the data and analyzed it in more then one narrow way.

This is really crappy academic research.
JW

Pfau's use of a widely-used valuation metric certainly is not data mining. It would be nice to see the results for PE8, PE12 and so on, but this is a quibble. You are missing the forest for the trees. Also, you are rude in the way that you convey your criticism.